Banks Won’t Be Bailed Out: Economy Isn’t Out of the Woods Yet!

Economy Isn’t Out of the Woods Yet!

The mystery is over, and the markets have achieved clarity – or that’s what some financial traders think, at least. Federal Reserve officials voted unanimously to increase the federal funds rate by 25 basis points this month, as expected. Yet, this doesn’t signal an end to the pain that the Fed is subjecting the economy and markets to.

Before you celebrate and start loading up on index funds, consider the facts. This is the Fed’s ninth consecutive interest rate hike, and it brings the fed funds rate to the highest level since September 2007 (and we all know what happened soon after that in 2008).

So, why would stocks rally a day after the FOMC meeting? As often occurs, the market is pricing in a best-case or “Goldilocks” scenario: investors assume a roughly 50% probability that Fed officials won’t raise rates again. By the end of 2023, they assume that the federal funds rate will fall below 4.2% ­– banking on the Fed cutting interest rates later this year – after topping out at just under 5% in May.

When the market prices in Goldilocks scenarios, bad things can happen. There’s no concrete evidence that the Fed won’t raise interest rates again. In fact, the FOMC dot plot points to another rate hike coming this year. Plus, seven Fed officials expect the benchmark interest rate to go higher than the currently anticipated 5.1% terminal rate.

Concerning the market’s assumption of interest rate cuts this year, Federal Reserve Chairman Jerome Powell specifically stated that “rate cuts are not in our base case.” It’s one thing to decide that you don’t believe what Powell says, but investors should always keep the saying “don’t fight the Fed” in the back of their minds.

Meanwhile, the bond market, which is typically more sophisticated than the stock market, is bracing for interest rate cuts, but only because it’s expecting a recession (which the Fed would “solve” by cutting the fed funds rate).

The bond market’s expectations are expressed through an inversion of the 10-year and 2-year Treasury note yield curve. As you can see in the chart shown above, the yield curve is as inverted as it’s been in a very long time. Moreover, inverted yield curves have preceded or coincided with every U.S. recession since 1980.

What we’re witnessing is a bizarre scenario in which stock and bond prices are moving in tandem. Thus, the old standby portfolio of 60% stocks and 40% bonds doesn’t protect retirees and other investors like it did for previous generations. That’s one of many reasons why precious metals offer superior portfolio protection to government bonds.

In case that’s not enough for investors to worry about, they also have to deal with mixed signals about the safety of bank deposits. Treasury Secretary Janet Yellen told members of the Senate Appropriations Committee that federal bank regulators are prepared to do whatever is needed to “ensure that depositors’ savings remain safe.” But Yellen also said, “I have not considered or discussed anything having to do with blanket insurance or guarantees of deposits.”

It doesn’t sound like Yellen has much of a plan, if any, to contain banking sector contagion. When and if a bank failure “is deemed to create systemic risk, which I think of as the risk of a contagious bank run… we are likely to invoke the systemic risk exception, which permits the FDIC to protect all depositors, and that would be a case-by-case determination,” Yellen told senators.

If that’s the backstop, then any bank with large quantities of government bonds (and this describes a lot of banks that bought into the “risk-free rate” narrative) could be in big trouble. In the coming months, don’t be surprised if the unsustainable foundations of the U.S. economy in the 2020s unravel quickly, leading to a reckoning in the economy and markets, but also opportunities if you know where to look for them.